If you’re struggling to cover your necessary expenses or pay down debt, you might feel like investing is out of reach. Just over half of Americans are invested in the stock market, mostly indirectly through mutual funds and retirement plans. Though wealthy Americans own the majority of stocks, investing is accessible to people in all income brackets. And if you choose not to invest, you’ll be missing out on the opportunity for your money to grow.
When to Invest
Many people wonder if they should invest while they have debt or lack liquid savings. A good rule of thumb is to save, invest, and pay down debt simultaneously. Trim your budget so you have as much income as possible to devote to those three goals. Always make sure you can cover the minimum payments on your debts, and then put any extra income towards your highest interest debt, your savings account, and a retirement account.
It’s important to start investing as early as possible so that you have a chance to grow your wealth. Investments earn compound interest, which means your money will grow exponentially. Let’s say you invested $100 per month and earned an average 6% return. After ten years, you’d have $15,817, even though your total contributions were only $12,000.
The difference between your contributions and the future value of your investments grows the more money you invest. But even if you have to start with a small amount each month, start investing as soon as you can. If you want to see how much you could earn, use this compound interest calculator.
How Much to Invest
The amount you invest will depend on your future goals, but one goal most people have in common is saving for retirement. Most financial experts recommend investing enough during your working years so that you’ll have 70 percent of your pre-retirement salary for each year of retirement. But since you don’t know how long you’ll live or whether you could face job loss, health issues, or disability, it’s best to stash away as much as possible. If you need benchmarks, Fidelity Investments recommends saving 1X your starting salary by age 30, 6X your starting salary by age 50, and 10X your starting salary in time for retirement.
Where to Invest
You should start by investing in tax-advantaged accounts. Not only will you receive tax benefits, but these accounts are designed for goals you should prioritize: Retirement savings and funding education for your children.
If your employer offers a 401(k), you should participate. If they offer matching, contribute the maximum and allow withdrawals directly from your paycheck. This is a way to “pay yourself first,” advice frequently touted by financial experts.
If you don’t have the opportunity to contribute to a workplace retirement plan, or you want to save more than the upper limit, consider opening an individual retirement account. You might also put money in an education savings plan if you have children. Once you feel confident that you’re contributing enough to those accounts to reach your goals, you can invest any additional income in an individual brokerage account.
Individual Retirement Account
Financial institutions establish IRAs for the sole purpose of retirement savings, and these accounts are either tax-deferred or allow for tax-free growth. However, if you withdraw from the account before age 59 ½, you’ll incur a 10 percent tax penalty. There are several types of IRAs, including:
- Traditional IRA: You can deduct up to $6,000 on your tax return, plus an extra $1,000 if you’re 50 or older, when you contribute to a traditional IRA. You won’t have to pay taxes on the money until you withdraw during retirement. You’ll be required to start taking distributions at age 72.
- Roth IRA: With a Roth IRA, you can contribute up to $6,000 plus an extra $1,000 if you’re 50 or older. Roth IRA contributions aren’t deductible, but grow tax-free and allow for tax-free withdrawals. You won’t be required to take minimum distributions during your lifetime, but your beneficiaries will need to.
- SEP IRA: Designed for self-employed people and small business owners and have higher contribution limits. Contributions are deductible and you won’t pay taxes until you take distributions. You can contribute up to $58,000 or 25 percent of your income, whichever is less. Catch-up contributions are not permitted. You’ll be required to start taking distributions at age 72.
Education Savings Plans
Accounts designed for education also have tax benefits — withdrawals are tax-free as long as they are used for education purposes. Contributions to a 529 plan are also deductible in some states, but never on your federal tax return. The most popular options for saving for education are:
- 529 Plan: These state-sponsored plans have varying contribution limits, but anyone can open one and friends and family can contribute. There’s a $10,000 cap on K-12 expenses, but you could potentially contribute up to $400,000 over your lifetime that can be used for post secondary expenses.
- Education Savings Account: Only individuals with a MAGI below $110,000 or couples filing jointly and earning below $220,000 can contribute to an ESA, which is also known as a Coverdell account. You’re allowed to contribute up to $2,000 annually until the beneficiary turns 18. They’ll need to liquidate the account or rollover the funds to another family member by age 30.
Individual Brokerage Account
Brokerage accounts aren’t tax advantaged — your capital gain will be taxed each year. With a brokerage account, you can transfer money into the account and it will be invested in securities like stocks and bonds. The fees for these accounts vary. If you’re a hands-on investor and want to actively manage your investments, you might choose an online broker. You can also choose an account managed by a human advisor, which typically costs the most but comes with expert advice. Or, you can choose an account with a robo-advisor that provides automatic rebalancing at a lower cost.
Keep in mind that in order to endure volatility in the market, you should plan to keep your money invested for at least five years. Depending on when you plan to withdraw the money, you should adjust your level of risk. If you’ll need money in the short term, choose a high-yield savings account, mutual fund, or certificate of deposit.
Common Types of Investments
Stocks
When you buy stocks, you’re purchasing a portion of a corporation’s owned assets and profits. You purchase these in units called shares. When stock prices fluctuate, your shares will gain or lose value. The goal is to hold onto your shares until they grow in value. Some corporations also pay dividends to shareholders. Most investment portfolios include stocks, but picking individual stocks can be time-consuming. If you want to reduce the effort, you may be better off investing in index funds, mutual funds, or exchange-traded funds.
Bonds
When you purchase a bond, you’re essentially giving a loan to a company or government. You get fixed interest payments at regular intervals until the face value of the bond is repaid. Bonds are generally less volatile than stocks, so keeping some in your portfolio will be beneficial.
Exchange-Traded Funds
An ETF is like a package of different investment types that can be traded like a stock. ETF providers pick a group of investments they think will track an index or asset, and investors can buy shares of the package.
Mutual Funds
Like ETFs, Mutual Funds allow investors to buy shares of a group of assets, which can help diversify your portfolio. But unlike ETFs, they are actively managed and can only be purchased at a calculated price at the end of a trading day.
Certificates of Deposit
If you’re looking for a more secure investment that you can cash in within five years, consider a certificate of deposit (CD) from a bank or credit union. You’ll deposit a lump sum that you agree to leave untouched for a period of time (anywhere from three months to several years) in exchange for a higher interest rate than you would be able to get from a savings account. If you run into an emergency, you’ll be able to withdraw the money early, but there will be a penalty.
Real Estate Investment Trusts
It’s a good idea to diversify your portfolio with alternative investments, and investing in a real estate investment trust (REIT) is one popular option. REITs own real estate, whether that’s a hotel, apartment building, or shopping mall, that generates income. Your investment earns a share of the rent, for example, that a group of properties collects. While many REITs are publicly traded, some are not, and those come with additional risks.
How to Invest Wisely
Set a Goal
You should set both long-term goals for retirement and education as well as short-term goals for things like home buying or a vacation. Having a goal will not only help you decide how much to invest, but will also help you determine your risk tolerance. You can handle more volatility in your retirement account, for example, because it’s a long-term goal.
Choose an Investment Strategy
As a beginner, you may want to avoid active trading. Buying and holding is generally a safer way to invest. You should also decide if you want to choose individual assets for your portfolio, work with a human advisor, or use a robo-advisor.
Diversify Your Assets
Avoid putting all your eggs in one basket. If you want to choose some individual stocks that you think might beat the market, you should also invest in funds such as ETFs or mutual funds. Once you have a variety of traditional investments, consider alternative asset classes as well.
Glossary
Alpha: This indicates how an investment performs relative to the market. Portfolio managers aim to beat the market return and generate alpha.
Beta: A stock’s beta data indicates how risky the investment is relative to market performance
Appreciation: An investment’s increase in value over a period of time
Depreciation: An investment’s decrease in value over a period of time
Inflation: The process of a currency losing value over time as goods and services become more expensive
Asset Classes: An asset class is a type of investment. Examples include stocks, bonds, and ETFs.
Diversification: The process of combining different asset classes in a portfolio to reduce overall volatility
Bear Market: When a market declines over time, typically 20 percent or more, it’s said to be a bear market
Bull Market: When most securities are increasing in price over an extended period of time, that’s known as a bull market
Buying Long: This refers to the purchase of a security with the expectation that the price will increase and the investor can make money from the future sale
Capital Gain: The profit earned on the sale of an investment or asset
Churning: This is an illegal practice in which a broker trades excessively, regardless of the investor’s goals, in order to generate more commission
Compound Interest: This describes the exponential growth of an asset due to interest accrued on both the principal and any interest earned in a previous period
Dividend: A portion of a corporation’s profits that is paid to shareholders regularly
Fiduciary: This indicates an advisor’s dedication to prioritizing the investor’s goals rather than earning commission
Security: Any financial asset that can be traded, such as a stock or bond
Shares: These represent a portion of ownership in a corporation that can be purchased by investors
Stock Market: A group of exchanges where investors can trade securities
Volatility: The increase and decrease in value of an asset over time, which can be used to measure the risk of a particular investment
The information contained herein is provided for free and is to be used for educational and informational purposes only. Consult a financial professional for specific help with your situation.